Why Real Estate Works – The Truth!

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Most of us on BiggerPockets are of the opinion that Real Estate represents the best opportunity for us to get ahead. But why – really?

I am of the opinion that if we are going to involve ourselves with real estate, it pays to understand precisely why things work the way that they do. Frankly – most people do not… This article is for those of you who enjoy thinking, once in a while.

Not too often, naturally, as we all know that thinking too much is bad for our health.  However, most realize that the act of thinking once in a while is good for our business, so here we go:

What is Money?

There are countless ways to describe the concept of money, but I think that we can all agree that in our society at its’ core money is just a medium of exchange.

In the early monetary systems, the value of money, which is to say value of “stuff” that one unit of money buys, was underpinned by tangible “things”.  Most of you likely immediately assume those “tangible things” are precious metals.

However, many of the books that I read to my children tell stories of value delivered through heads of heard, Persian rugs, and even salt, which believe it or not was very rare and therefore valued in certain cultures at certain times.

However, an obvious problem with paying for stuff with heads of herd is simply that while valuable, a herd of animals is difficult to store and transport.  Aside for storing universally accepted value, a medium of exchange should also be convenient and utilitarian in order to be effective…a herd is neither.

As people continued to search for a more utilitarian unit of money, they eventually arrived at precious metals which, it was felt, due to their relative rarity possessed intrinsic value, but which could be minted into small coins making them easier to transport and utilize in trade.

Well, while metal coins were much more convenient than anything that came before, carrying around a bag of gold coins still left something to be desired relative to comfort.

After all – imagine going through the day trying to keep your pants from falling due to being weighted down by two-kilo bags of coins in each pocket…

Who is Best at Solving Problems?

You guessed it – bankers.

Yeah baby, these guys are always the smartest people in the room (specifically when they are the only people in the room) and they always have the answers.

Related: How to Create a Compelling Elevator Pitch to Your Lender

The bankers said: Hey guys – we know this money is hard to schlep around town all day, so why don’t you leave your coins in our vault, and we’ll give you a little paper Bank Note in the amount equal to your deposit.  You can come back and use this Note to redeem your coins any time you want, and in the mean time you can simply conduct your trade with them – our Bank Notes are good as gold!

How convenient – now all folks had to carry around were a few pieces of paper…

This Was the Beginning of the Problem

Why – you ask?

Because it didn’t take the bankers long to get wise to the idea that the chances of all of the depositors showing up and demanding every ounce of the money they had on deposit at the same time was negligible.

Sure, the bank has to have a certain amount of money available to pay out to those people who do come in and claim their deposits, but this amount is a fraction of the total amount on deposit – let’s say 10% for example.

Naturally there is much more to this, but the end result was that only a small percentage of all money in circulation was real, or collateralized by intrinsic value of the precious metals in the volts of the banks.

The rest were just IOUs.  Say hello to Fractional Reserve Banking! But, needing to collateralize even 10% of the money soon became impossible since there wasn’t enough gold in existence, which led to an eventual decoupling from the metal all together.

Say hello to Fiat Currency. Now the banks can create as much money as they want, which is convenient for the governments since they can pay for wars and social programs without worrying about running out of money…NICE, everyone is happy! Moving along:

How Money is Created

Banks don’t lend money that they have.

Instead, they create as much money out of thin air as they need. When you go in to ask for a loan, and you are approved, an entry is simply created on the bank’s balance sheet indicating that a loan has been made.

This entry creates fiat money which enters the circulation.  That simple… Robert Kiyosaki explains to us that this loan is an asset for the bank and the entry is made in the asset section of the bank’s balance sheet.  Not a bad set-up if you ask me.  The rest of us have to “buy” assets with our hard-earned cash, but not the banks – they just create the money.

But, I’ll go a step further than Kiyosaki in saying that it’s not the loan that constitutes the bank’s freshly minted asset – it’s the borrower! Having created this money, the bank now expects you to pay it back – do they not?

Of course they do!  And not only that, but you are also expected to pay interest on this money.  Think about this – the bank creates money it did not have before, to lend it to you, so you can pay interest on this money and make the bank rich.

Pretty cool set-up – if you are the bank. Question: Can you, just like the bank, create money out of thin air with which to pay the back your debt and interest? No?  What a shame! This means that what you must do is work, work, and work some more to EARN the money with which to pay the bank back. You are the banks asset, and that’s putting very mildly…

A Way to Look at This:

Looking at this situation we could say that having created money to lend to you out of thin air with just a stroke of a pen (or by pushing down a few keys on a computer keyboard), the banks are then able to generate profits by charging interest that you must “earn”.

Banks do not create monetary supply with which you can pay the interest; they only create monetary supply that is the principal.  This means that you MUST work to earn the money – it’s the only way (for most people)!

This is important: In our economy, due to what I just described, debt is an asset to the economy and to the government because in a debt economy such as ours debt necessitates your (and everyone else’s) productivity.  The more debt you carry, the more productive you must be to support your habits, which is why I choose to live rather frugally (wink, wink).

So, do you see that by borrowing money to support your life-style you relinquish control over your productivity to the bank and our economic system at large?

A few banks, who belong to private shareholders, who are at the top of the economic food-chain, and who control most of the investable wealth in the world, lend money out to the rest of us in return for interest which ropes most of us up into trading hours for dollars for the rest of our lives…

There is Another Way – Income-Producing Real Estate

While I could go on about this kind of stuff for hours, and this barely scratches the essence of the beast that is the fractional reserve banking system, which, incidentally, will most definitely for reasons none other than simple math be our downfall in the end, I must inject some positive perspective into this otherwise gloomy and some-what disturbing article.

Related: Income Real Estate Investors: Learn How to Analyze a Property before you Get Burned!

This positive perspective will come at a price of humility, but at least it’s something… While it is virtually impossible to avoid being economically controlled unless you are independently wealthy, it is indeed possible to offset the effects. Think about it…I borrow fake money at the bank.  I then convert this money into income-producing real estate.

And if I do it right, the rents coming in from my tenants pay the principal and interest associated with my borrowing.  In this way, while I am still on the hook to the bank, chances are better than not that OTHER PEOPLE will pay off my debt.  Put another way, it is my tenants working hard trading dollars for hours at their jobs – not me, and in this way I escape the system of productivity!

Furthermore, as my notes to the banks get paid off, I will gain access to equity which I can liquefy and – become a lender myself!  That’s right, I will be able to turn the tables in my favor… Do I feel great about having to effectively lay all of the burden of my financial gain on the shoulders of my tenants – no; I do not!

But, I do it because the system is designed in a way that forces me to do it, and I sure as hell don’t want to waste myself trying to change the system. There is a game going on, and several statements seem true relative to this:

  1. You can’t win if you don’t play
  2. You can’t win if you don’t know the rules
  3. You can’t win if you don’t have the right tools

Conclusion

Much more needs to be said, but in more ways than one this story really is just about grabbing a piece for yourself while there’s still time.

This isn’t a right vs. left, progressive vs. conservative, democrat vs. republican story.  EVERYONE at the top of the economic food-chain is all in at this stage of the game.

My advice to you – learn the game and try like hell to grab a piece!

OK; this is enough thinking for a Tuesday morning…

Want to talk about this?

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About Author

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

38 Comments

  1. Great article, Ben. This is something 99.9% of Americans do not understand – they think deposits create loans, when in fact it is the other way around. I happened to be one of the misinformed not too long ago, so it was refreshing to read this blog and actually understand what the hell you are talking about :)

    One question though. I think I know why you said it, but wondered if you could expand on this comment:

    “…which, incidentally, will most definitely for reasons none other than simple math be our downfall in the end…”

    Thanks – looking forward to all the comments that should ensue from this post ;)

    • Hey Sharon – thank you for reading!

      The economy is most simply understood as a certain number of units of currency chasing certain number of goods and services. You simply can not inflate the number of units of currency in circulation indefinitely without throwing this “balance” off. Are the needs of our population growing sufficiently quickly to “collateralize” all of the currency we are printing…? Something to think on :)

      BTW – wonder why the republicans are jumping on the immigration reform bandwagon all of a sudden? We need more people to buy more shit in this country for when inflation hits. Even if that “shit” they are buying is subsidized edu, health, and all the rest. The organic growth can not support the currency supply we’ve got… This isn’t a right or wrong human issue, nor is it democrat vs. republican. Both sides belong to the people in control of the banking and more specifically the FED…

      Now – at the moment, the other big piece is something called VELOCITY of money; there is none. Corporations are hoarding cash, which is why the inflation is under control. This can’t go on forever.

      • Well Ben, if by “printing money” you are referring to QE, that technically was a swap of assets and not printing money as mainstream media would have most believe (see #5 here in this excellent article http://pragcap.com/biggest-myths-in-economics).

        Having said that, this money has been sitting on bank’s balance sheets for a while, as you point out, because bank’s and consumers are gun shy from the last recession (supply and demand are at a stalemate), and consumers’ wages are stagnant. If and when that situation reverses and banks start lending again and people start spending again, the Fed will have to “slowly” unwind QE, pulling money back out of the economy. This process occurs over and over again in history, which is why I am not in the least bit worried about a math error causing the downfall of the U.S. economy. My 2 cents, for what it’s worth.

        I do agree with your overall point, however, to focus more on hedging our bets via REI rather than sitting on the sidelines worrying about something that may or may not happen.

        • Well I will accept that position gladly :)

          And quit worrying – it’s bad for your health!!!

        • Sharon, thank you for the link to the Biggest Myths. Both these articles are very interesting and informative!

        • You’re welcome, GK! Spending some time on PragCap will give you an excellent education on the current economy without the political slant or fear mongering rants that are so commonplace in today’s misinformed media. I also like this link a lot too if you care to learn more about how our monetary system really works: http://pragcap.com/the-best-of-tpc

      • Jerry Kaidor on

        which is why the inflation is under control

        ….Is it? I don’t know. Computers are cheap, but I cringe whenever I enter a grocery store. A quick websearch for “real rate of inflation” reveals that the government has been cooking those books for years, mainly to save money on Social Security, which is tied to the “official” rate of inflation, per act of Congress.

  2. Great article, Ben (esp. for an otherwise dull Tuesday morning!)

    I feel all the better to be owning a lot of real estate where my tenants are working hard to pay these banks (so that I don’t have to). It sounds mean – but as you say, it is a game and we might as well be on the winning side.

    • Ha – the sad reality is that while in playing the game you are certainly better off than most, winning you are not I am afraid. But, you have to go through this stage to get to the next; to develop a vision for what’s beyond…

      We’ll see what tomorrow brings my friend…thanks indeed for leaving a comment on an otherwise boring Tuesday morning :)

  3. Ben, what is you plan of action when an emergency, requiring a long hospital stay, happens or when you/your family members need a long term care. These things have nothing to do, or let’s say, little to do with a life style, they just happen no matter how frugally you live. I support a frugal life style, but I would buy a brand new car because it’s loaded with safety features and will keep me out of a hospital better than a 10 year old car. Do you splurge in your frugal lifestyle on a disability and long term insurance, or not? Do you have any other arrangements?

    Thank you.

    • Galya – I think that long-term care policy is an appropriate product to evaluate for a lot of people. Same as term life.

      Having said this, I am a very bad example. I have never had a job (not since high school). I diversify revenue streams extensively between Property, CFFU and books, music students (which can be taught even while in a wheel chair). I no longer “DO” anything for money that can not be perpetuated even if fair amount of distress occurs. My wife still trades about 25 per week for money, but with Syndicating I’m trying to put an end to that. I only manage…MS has caused me to view life from this perspective for a long time :)

      Finally, I re-invest like crazy into amortizing my notes. We are all on borrowed time, and have to “hope and hang on”. But, the way Patrisha and I have positioned ourselves we will need to “hope and hang on” for a shorter time than most. For now – sure, but not for too much longer…

      I hope this answers you comment sufficiently – thank you!

      • It’s good enough, thank you.

        I have a medical background and even though we are very healthy and with my background I can tell doctors what tests I want or don’t want, I also know how much things cost (ex. triple bypass about a quarter million before the insurance or a night in an ICU a couple of thousands). I always wonder what other people do, plan and so on.

        BTW, once upon a time I worked in a lab that discovered Copaxone (not sure if I’ve mentioned it or not).

  4. What an interesting and educational post! Thank you. I will go back and read it more slowly a second time. I feel that the tangible asset of real estate is a superb hedge against inflation because the underlying materials must essentially keep up and the rents must also keep up with inflation (to a greater or lesser degree).

    I have only 6 rental houses in addition to my paid off abode and am working like a mad man to get them paid off. 4 down, 2 to go. One of the remaining two is getting very close and will likely be paid off by Dec/Jan. I am snowballing for a rapid payoff while blogging about the experience. After I’m finished, I’ll probably go against the tide of this article and pay cash for future purchases, but that’s where I am in the “comfort zone” of real estate investing. I don’t want the mortgages anymore.

    Anyway, I’m off to re-read your post again. I look forward to more like this.

    Curtis

    • Glad you enjoyed it Curtis – once in a while I get lucky and pop out a good one :)

      I don’t disagree with your thoughts nor strategy. Paid-off property has to be protected relative to liability, but I am sure you are doing that.

      Thanks so much Curtis!

  5. Galya,

    Please don’t be lulled into a false sense of security with disability and long term care insurance. Make sure you go over the policies with a fine tooth comb and extract the fine print. A good rule of thumb with any financial product is that if it is heavily marketed and pushed upon you, it’s usually a bad deal for you and a good deal for the insurance company. For example, with disability policies many have fine print they will only pay out when you can’t do *any occupation* and not just *your occupation.* So if you’re a real estate contractor making good money rehabbing and have an *any occ* policy and you get hurt on a job site, your disability insurance will tell you that you still can teach or be a greeter at WalMart and you will have to do that before you get paid. With long term care insurance, the big catch that’s found with most of those policies is that the insurance company can change/raise your premium *at any moment*. So, you’ve been paying religiously for 20 years and you have not needed it and then boom, you need it…well shortly after needing it they will likely raise the premium on you. They are notorious for raising the premium on certain birthdays as well (i.e. after you turn 59). If you are into real estate already, why not consider purchasing a small 6 or 7 bed rest or nursing home on your own or with a partnet and then house yourself and spouse within it all the while taking 5 other patients to pay the bills for the staffing? This way, medicare will be paying you for your own care instead of paying another nursing home to provide care for you.

    • Thank you for the info, Adam.

      I know that disability is better to get through your work, provided you have a job, not a business.

      I have been thinking about it, having my nursing home. From what I can tell, it needs to be heavily financed through a governmental program (more than the medicare) to bring any money “home,” otherwise it either makes money but the service is barely passes the standards of care, border-lining on being closed, or it’s just going to eat all the profits. There are just too many regulations in this type of things (and to be reimbursed by the medicare), how many nurses per pt, how many doctors per pt, PTs, occupational therapists, speech therapist (for your stroke residents), and so on, who can pass meds, who can prescribe meds, plan of care and so on and all this is required. If I’m going to manage all this, I can’t be a resident. Might be easier to just hire a few CNAs or LPNs and make them come to my house.

  6. Ben,
    Interesting article and forgive me if I am missing something totally obvious but where does that big bag of money the seller gets come from. Or is that invisible too.

  7. David Laplante on

    Wow! How’s that for enlightenment! Thanks for a very well written article! Yours are always geeat articles that I read with passion!

    Thanks!

  8. Great breakdown Ben. Knowledge is truly power. I am slightly worried about our nations future because I also believe that 90+% of the US population does not understand the operational realities of our monetary system. The FED has a satisfactory handle on monetary policy but the congress is horribly inept with their control of fiscal policy. Overall I am confident that when there are no other options our leaders will do what is neccessary.

    I don’t think the average person understands, I mean really understand the weight of your 3 statements regarding the economic game.

  9. I usually love your articles Ben…..this one didn’t do it for me. Way to pessimistic. If the average human lives around 80 years, and the universe has been around for billions of years, it appears to me that we live here for a very small amount of time (lol). We might as well choice to be a bit more optimistic. Why the hell not?

    When the end of the human race comes, and it might very come due to all of our debt, then so be it. But to live with such a pessimistic view of things seems, to me at least, kind of silly.

    I know you are just sharing your opinions. I know you don’t mean any harm by what you are writing…..but I can’t tell you how many people have stopped investing their money due to all the pessimism out there. I know plenty of people who sold their stocks in 2008-2009 and haven’t gotten back into the market as it has rallied over 100%. The fear got too them…the pessimism got too them….they began believing the articles saying “this time was different” or “this is the end of capitalism”.

    When the end of capitalism (or the human race) actually does happen then who the hell cares where your money is. But, until that day comes, I’d like to think that things are moving in the right direction, that humans are better off now than they were 200 years ago, and that by investing money for the future and being optimistic about it, is a much better way too look at things than the alternative.

    • LOL Dave – there’s a difference between pessimism and fear. Fear is paralyzing, while pessimism is sobering. You don’t see me sitting and moping – I take action with eyes wide open, and I spill it for you guys on this blog and mine. Action is the key difference…

  10. Jarrod Weaver on

    Having recently begun reading The Creature from Jekyll Island which exposes the illusion that is the FED I feel that I know exactly where you are coming from Ben. I too am very pessimistic about the economy (Since it is created from vapor it is guaranteed to collapse.) and the overall state of affairs globally.

    One difference I have from many critical of your post, is that it is the reason to go all in – not standby waiting for things to improve. It isn’t going to happen. Jump in, provide value to other humans, make money and do good things with it.

  11. George Smith on

    Excellent article and one that young adults really need to understand but are rarely taught. It’s amazing how many times you’ll ask a young adult what a fiat currency is and they haven’t a clue.

  12. Ben, this is the best column that you have ever written. It was a pleasure to read.

    In all of the reading of fiat currency and fractional reserve lending, you manage to explain it more succinctly than most can.

    Writing articles like this is important. Real estate investing begins with a compelling answer to the question “Why?”.

    • Everything in life begins with a compelling answer to the question WHY – I concur Keith!

      I am glad you enjoyed this piece – just something old I pulled out of the closet :) Wait til next week…

  13. A well-written, informational article–you’ve connected many dots for me. Thank you! I’d like to see more like this. And more about the fractional reserve system. =)

  14. Thanks for the article and the insights. One point that’s worth further mention is the way banks create money through loans. If Bank A gives me a $500 loan to go buy a car, and I take that loan in cash, the bank gives me cash that other people have deposited at that bank. Banks actually do lend out deposits. This is still the creation of money since that $500 in cash now has two claimants on it, the initial depositor, and me. If the seller of the car takes that cash and deposits it back at Bank A, this would be essentially the same as if cash never left their vault and they created the $500 out of thin air, as is described in the article. If, however, the seller of the car deposits that cash at Bank B, then it is not the same. Unless the loan the bank makes ends up as a deposit at that same bank, then the bank must actually lend out money they acquired through deposits. Anyway, it’s a little more complex than this but fundamentally, banks create money by loaning out deposits, not exactly by creating it out of thin air.

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